Monday, July 9, 2018

Risks of Diversification - Weekly Blog 532

While many major fortunes have been made through the aggressive devotion to a single investment, most risk aware investors rely on diversification as an important defense mechanism. These investors believe that they are diversified by allocating their portfolio into domestic equities, international equities, domestic and foreign debt, commodities, and cash. I believe that this allocation schedule does not fully take into consideration the risks that we are exposed to as people and investors for ourselves and others.

Three Biggest Risks

The largest single risk is the lack of recognition of the existence of the “unknown unknowns.” Another way to label this is surprise risk. We are regularly surprised, not only by events but also by the long-term significance of the events. The best defense against this primary risk is to array our financial and intellectual assets and liabilities in terms of their flexibility. We should be able to quickly redeploy some of our assets and liabilities. As we get older and have grater responsibilities it gets harder to pivot to new threats and opportunities.

The second biggest risk is the supposed need for a perfect plan for the future. Recognizing surprise risk, we should be able to devote some of our most precious time and investment capital to explore areas that are unknown and probably uncomfortable. In the US Marines we call this recon, short for reconnaissance. (It was Robert E. Lee’s discovery of the sunken road that led to an important victory in the first US war with Mexico. (“From The Halls of Montezuma to the Shores of Tripoli” are the beginnings of The Marine Corps Hymn.)

The perfect investment plan belies the only guaranteed product of investing, humility. When interviewing potential portfolio managers to invest our clients’ money, we want to know about their mistakes. If one has a very short list or none at all it becomes a very short interview. One of the refreshing points in listening to Warren Buffett and Charlie Munger is their frank discussion of their past mistakes. One of Charlie’s biggest compliments of Warren is that he is always learning. Charlie himself is anxious to learn every day, as am I. Being wrong comes with the territory, hopefully it does not have to be repeated, but often it requires multiple lessons to change behavior.

Derived from the first two big risks is a third. The risk of lack of thoughtful assessment can be a hazard to our survival and growth. We learn little from pats on the back and much more from hits to the gut. While the pain of an acknowledged mistake in our thinking is useful, the real reward for making mistakes is the eventual recognition and adoption of new thinking. The more defensive we are, the more difficult it will be to derive the full benefit of our mistakes. Thus, the mistakes will become more expensive and frequent.

Comfort from Popularity Risk

As all humans are insecure, whether they admit it or not, they look for comfort in quick solutions. To cater to our insecurities we are drawn to what others are doing. This is particularly true when we are under great stress. If we believe others are collectively doing something, how can that be a mistake? That is unless one looks at the dissatisfaction of the majority of voters at the end of a politician’s term, or spend pleasant afternoons at the local racetrack where favorites on balance win only 30-40% of the time. More importantly, the winnings are relatively small and do not equal the money bet on the other favorites that did not win.

Currently, one of the big pushes by some investment advisors, particularly those that are addicted to building portfolios of only ETFs, is factor investing. There are many different factor options for investing, from statistical sorting to sector investing. I suggest looking at the latest five year record of the average mutual fund separated by investment objective. The following data is from my old firm, now part of Thomson Reuters:

Investment Objective      Av. Annual Performance     # of Funds
US Diversif. Equity            +  10.71                             8,385
All Equity                                     9.01                            15,116
World Equity                               6.88                              4,456
Mixed Asset                                 6.28                             5,916
Sector Equity                               6.16                              2,275
Domestic LT Fixed Inc        2.38                              4,174
World Income                              1.43                                750

Sector investing is difficult in the long run, but can be narrowly successful. The best sector for the five years ended July 5th 2018 was Global Science/Technology +22.07%. Some of those stocks are also in the US Diversified Equity leader, Large-Cap Growth +15.23%. They are among the most heavily redeemed group of funds as investors complete their risk exposure investing. The critical question is whether performance is the best guide for the next five years. I doubt it. Much more difficult is to guess where the new performance leadership will come from. In the future it may be a good bet that some or all of the seven different commodity fund investment objectives will become leaders. Since commodity cycles are typically long, five years may be too short a period of time.

Investment Instrument Limitation

Not wanting to rely on investment judgment, regulators have limited the options available for investment. For example, many trusts and some mutual funds are not able to invest directly in commodities themselves. Other restrictions require only publicly traded securities or Investment Grade bonds. Most brokerage firms can not act as custodian for the securities traded out of their home country. There are other restrictions too; some caused by limited scope of the investment advisor’s administrative support mechanism. Almost as with the US experiment with the Prohibition of liquor, adventures beyond the walls of limitations become attractive in and of themselves. We sense that the games only a selected few can play are more exciting than the ones we are allowed to play ourselves. For some investors it may be worthwhile to find advisors or banks that can facilitate narrower investment opportunities with some lack of legal support.

Two Personal Limitations

The first limitation is the mind set of the investment advisor who wishes for sound business reasons to keep all accounts invested in the same products and allocations. Some gatekeepers object to great dispersion among a manager’s portfolio. Life would be much easier for the gatekeeper if he or she can be reassured that a new account will look exactly like the others. I am sure that you have visited museums where every picture is the same. I haven’t and don’t want to. Good investors are painters who evolve over time. Clearly, limitations faced by investors is the unwillingness for tax and emotional reasons to accept gains for tax purposes and losses for emotional reasons. Actually, the limitation may be at the advisor level, not wanting to see assets decline for fear of failing to meet tax obligations.

The final set of limitations to diversifying a portfolio broadly are our own biases. Our brains are memory devices and we find comfort in what we know or think we understand. Even with my Caltech trustee exposure I don’t really understand the science behind most biotech ideas and companies. Thus, I don’t own any biotech stocks...directly. I have chosen to use a couple of mutual funds that have medical doctors as part of their portfolio management teams. This is the way I deal with this limitation.

The Final Limitation

We only have so much time left and luckily we don’t know exactly how much. So we hope that we can learn every single day, as do Charlie Munger and Warren Buffett

Noise, Direction, and Premature Action

Liz Ann Sonders of Charles Schwab put out a piece on July 7th entitled “Just Noise or Something More.” She focuses on the ratio of noise to importance. Last week I ventured that nothing of significance would happen on July 6th. While the US and China raised tariffs, I believe these were firecrackers not artillery. The Chinese President surrounds himself with engineers who think long-term, whereas the US President is more comfortable with generals and others that have served in the military. Combine this with the upcoming NATO and Helsinki meetings and the real game is revealed. President Trump is using an imbalance of merchandise trade as a fulcrum to address a weakened US Defense position. The President sees a shift in balance in terms of technology, a sub scale Navy to fight a two ocean war, insufficient troops and the will to defend Europe, the Middle East and African proxy wars. His major strength is that the US is the single most profitable market in the world. He is attempting to force others to give him the room and time to correct for the imbalances. His great trading advantage is to make the US market less profitable. Almost none of these views will be found in the noise of the popular press or through their politicians and therefore may be more right than wrong.

I suspect many of these thoughts and concerns will become clearer by the Fall, although they’ll not necessarily be solved. Barron’s, writing about the trade war, believes that new index highs are unlikely until things become clearer. From a market analysis standpoint we appear to be in a transition. The question is whether we are seeing accumulation by smart investors or distribution of their holdings to less smart investors. I don’t know the answer, but to me the odds are that investing in global equities is not an unusually high risk currently. This might be translated into a cyclical decline in the vicinity of 25%, but not a secular fall of 50% or more. On the basis of those downsides I am looking for opportunities to buy long-term bargains.

Recognizing that I am probably premature, there are two asset classes that should be considered. The first is World Equity Funds.
I am particularly drawn to the list in Barron’s of the poorest performers in the latest quarter. A number of these funds have a history of being good performers. Some of the poor performance is due to the rise of the US dollar relative to other currencies. This is particularly true up to July 3rd in the Yuan. In addition, the Chinese market in local terms has been weak, in spite of its rising long-term prospects. The second asset class that deserves appropriate study is commodities and commodity funds. For the last five years commodity funds are just about the only group to show negative results. Commodity prices move up because of shortages, more so than an increase in demand. While many old commodity players believe they move in twenty year cycles, it is possible that the longevity of their decline will be shortened, with growing demand and the lack of capital expanding capacity.

Questions: What are your reactions to some or all of these controversial views? Please let me know privately.
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Sunday, July 1, 2018

Value Can Lead – Weekly Blog # 531

A Possible Turning Point

July of 2016 to June of 2018 may have been a turning point. Interest rates started rising to meet commercial demand for loans, even before the political conventions. Three weeks ago we began seeing that tech-led Growth funds were no longer the weekly mutual fund leaders, value is now leading. In a gross oversimplification some people divide equities between growth and value. According to a table in the weekend edition of The Wall Street Journal, looking only at the sectors within the S&P 500, note the following weekly performance:

Utilities               +2.25%
Telecom Serv      +1.18%
Real Estate          +1.06%
Energy                 +1.03%


Information Tech         -2.19%
Financials                     -1.93%
Consumer Discretion  -1.87%
Health Care                  -1.79%

One could choose to ignore very short-term performance results, which is normally wise. However, a glance at the charts of the three major stock indices might well suggest that there is a potential warning in the near-term data. Both the Dow Jones Industrial Average (DJIA) and the Standard & Poor's 500 (S&P500) are showing reversal patterns and the NASDAQ Composite (NASDAQ) could be as well. Clearly something has changed and this could be labeled sentiment. The American Association of Individual Investors (AAII) conducts a sample survey of its members which can be quite volatile and the sample may not be representative enough. Nevertheless, it is worth noting that in a three week period, bullish responses dropped 37% to 28.4% of the sample and bearish responses rose 88% to a reading of 40.8% of the responses. (The causes for the sentiment shift will be discussed below.)

A Positive for Value

While some may disagree with me, I believe from a low level the increase in interest rates is a positive for those who are looking for value. The search for value is much more difficult than the search for growth in rising revenues and earnings. While many value advocates speak of intrinsic value, what they really mean is what price a knowledgeable buyer for the company would pay. Therefore, value is a derivative of the price of a transaction. Value-oriented investors attempt to arbitrage the difference between the current price and a future expected transaction price. If one believes in the commonality of assets, a similar transaction price for some could establish value or at least be indicative of it.

Rarely have I found complete commonality of individual assets and thus an adjusted price becomes the theoretical price, with the buyer really determining the value. Most buyers want to earn a premium over their cost of capital and therefore higher interest rates drive acquisition prices. Commercial interest rates imply that they have imbedded within them a credit cushion for bad debts particularly for commercial loans as distinct from borrowings by governments. Thus, in late June and early July of 2016, after the end of an undeclared recession started to raise commercial interest rates, buyers could foresee the profitable use of loans. Thus the beginnings of a new expansion started.

Cash Flows

One of the first tasks we learned from Professor David Dodd was to reconstruct financial statements so that they could be used by investors instead of creditors. To me the single most valuable statement for determining value was the Cash Flow statement, which is rarely commented upon by the pundits. Recently, when I looked at one of these documents it became clear to me that the proper reconstruction is dependent very much on the intended use by a potential acquirer of a company. Acquirers could be quick liquidators, passive investors, a buyer of talent, customers, patent seekers, or others desiring excess capacity and unique assets. In some cases the acquirer may want to remove capacity from the market. The following is a brief list of items found on the cash flow statement that should be handled differently depending on the user: depreciation/depletion policies, property, plant and equipment, acquisition or disposals, repurchase of company stock, repayment of debt, and dividends.

As a practical matter value is not only dependent on interest rates, but on the willingness of others to extend credit to businesses and individuals. Currently, we are seeing a surge in the willingness to offer credit, which is a counter-force to the central banks wanting to raise the price of money. I am concerned that the pressure to offer credit may lead to narrower profit margins, resulting in lower than appropriate reserves.

Stability Leads to Instability

At some point this over-extension of credit creates a vulnerability which could create a major distortion of risk and lead to a recession. Right now credit reserves look to be stable; however, please remember a quote from Hyman Minsky, “Stability leads to instability. The more stable things become and the longer they are stable, the more unstable they will be when the crisis hits.” Instability could mark the end of the current phase, making investing for value problematic.

Shifting Sentiments

I have already noted the somewhat dramatic shift in market sentiment. Many will attribute it to the troubled trade discussions. I personally believe the shift away from the tech-driven growth favorites was overdue. At least on a temporary basis, some retrenchment was to be expected in terms of excessively large positions.

In dealing with short–term trade movements it may be worthwhile to focus on July 3rd and July 6th.  The first date is another example of the media-political-academic complex wrapping history to their own needs and ignoring the real motivations of the principals. On July 3rd, 1863 the final day of the Battle of Gettysburg was fought. Robert E. Lee, probably the smartest American general, sacrificed some of his best troops in charges up a hill to breakthrough the Union lines. Most history books state that if he had won the day he would have pivoted and attacked Washington DC, likely resulting in the desired end of the war.

Looking at a map and understanding where the Union’s economic strength lay, as well as what was happening in Vicksburg on the very same date, shows me a different set of plans. If the Confederate forces had broken through in southern Pennsylvania they would not have pivoted, but instead headed north to disrupt the rail and other east-west train traffic. This would have isolated economic parts of the North and could have taken some pressure off the battle of Vicksburg, which was about to fall to Sherman, leading to the destruction of the South’s war making capability on Sherman’s march to the sea.

Bearing in mind another example of the general public being misinformed, we may be seeing a similar mistake in terms of perceptions of the trade/security issues we are now facing. On July 6 the scheduled implementation of the Trump tariffs is meant to happen. To my mind the trade issues are not the real focus of the current US Administration, security is.   

For whatever it is worth I do not expect anything of significance to happen on July 6.

What do you think on the switch to value and the trade and security issues?
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Wednesday, June 20, 2018

The G7 Meeting in Its Demise as a Policy Making Body Was Useful - Blog # 529

The current focus on worldwide tariffs, particularly those of Chinese and American products, was kicked off by President Trump at the G7 meeting held  in Quebec. 

·       Mohamed El-Erian, formerly head of PIMCO and now chief economic advisor to its owner Allianz, recently stated that “The failed G7 Summit dealt a very public blow to a once powerful grouping that had already been challenged by global economic re-alignment, the emergence of the more representative G20, and new forms of regionalism.”

·       Today the leading German auto manufacturer suggested that there be no tariffs on autos within the market that uses the Euro. This is a reaction to a suggestion that the American President made at the meeting.

My blog post last week, entitled “Learning from the Demise of G7 through the Battle of Cowpens,” is available by subscribing to my blog.  To become a regular reader simply send me an email at .

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A. Michael Lipper, CFA
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Sunday, June 17, 2018

Learning from the Demise of G7 through the Battle of Cowpens - Weekly Blog # 528

I learn and apply these lessons to our investment tasks, communicating them through these blog posts. Global policy judgments are not a focus of these blogs. One can learn from watching conflict resolutions in military, political, and sports worlds that are useful in thinking about future investment decisions.

The G-7 meeting

The G-7 meeting in Canada was a wonderful display of tactics that may predict future strategic movements. President Trump was widely criticized before the meeting as a protectionist, particularly by European allies and Canada. In a brilliant flanking move, he surprised them at the meeting by suggesting a relationship with no tariffs or other barriers to trade. What it revealed was that each of the other countries involved had higher tariffs and more trade constraints than the US. The reason for the discomfort (or more correctly, horror) was that these were put into place to benefit specific politically powerful interests, which would presumably be hurt in a no-tariff world and would cause most of the governments at the meeting to fall. (The US is very conscious of the tariff wall which was the primary cause of the early conflict between the Northern and Southern states and thus really led to the Civil War.

The future may well depend on how close a parallel this is to the Battle of Cowpens during the Revolutionary War and its aftermath.

The Battle of Cowpens

The Battle of Cowpens, fought in 1781, was an engagement between American Colonial forces under Brigadier General Daniel Morgan and British forces under Sir Banastre Tarleton. Tarleton’s force of 1000 British in the King’s Army went up against the 2000 men under Morgan. Only 200 of the 1000 British troops escaped the battle. The Colonial forces conducted a double envelopment of Tarleton's forces.
From the American side, almost equally as important, they lost two major cannons that could have helped the Colonial forces at Yorktown.

Tarleton was a young and impetuous commander who marched tired troops into battle and fell into a well designed trap of counterattacking by the Americans. The Americans were instructed to fire two rounds and then retreat into the hills, sucking the tired troops into fire from three emplaced positions with their open flank. That is where the American cavalry showed up, having circled the British lines.

The battle was a turning point and coupled with the British defeat at King’s Mountain, compelled Cornwallis to pursue the main southern front of the American Army into North Carolina, leading to Cornwallis’s surrender at Yorktown. Quite possibly, if Cowpens had turned out differently, there might have been a British fleet off Yorktown rather than the French fleet and the US would have remained within the British Empire a little longer. Except, unknown to the participants, a peace treaty had already been signed in London, with considerable help from some members of Parliament.

Clearly the tactics at Cowpens may have had a role in the strategic reorientation of Britain and the United States. Could this also happen to the make-up of the G-7? Was the difficult meeting in Canada a part, perhaps a necessary part, of the pivot to Asia?

Investment Lessons

The following are possible parallels from the G-7/Cowpens actions:
Read more fully about the past and look for less popular, simplistic explanations.
Be careful about following young, impetuous leaders.
Early gains can be a trap.
Rest is an important ingredient for victory.
Don’t leave your flanks unguarded.

Follow-Up Bits

Everyday we are greeted with bits of information, rarely however do we get the complete picture. Often, the bits are in conflict with each other and formerly perceived “truths.” The following are listed in order of their published date.

Money Market deposit account interest rates jumped to 0.52% vs. 0.47% before the Fed raised rates by 25 basis points.

The American Association of Individual Investors (AAII) weekly survey turned roughly 5 percentage points more bullish, dropping 5 percentage points from the bearish category. [At this level, rising short-term interest rates are apparently viewed as bullish.]

Mutual fund investors around the world are primarily investing for long-tem needs, largely retirement. At the end of 2017, US investors owned 44.8% of the $49.3 trillion invested in Funds, with only 31% in equity funds. Of American households, 45% own Funds, with 61% owned in tax deferred accounts. Thus, conventional mutual funds are unlikely to be the leaders in the next speculative surge in the market.
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A. Michael Lipper, CFA
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Contact author for limited redistribution permission.